Diversification and Value Migration

Diversification and Value Migration

The financial services industry has been the lead story almost every day this month – unfortunately for all of the wrong reasons. The demise of Silicon Valley Bank, Signature Bank and Silvergate Bank all in rapid succession has sparked shock and fear: how could this happen to regulated well-capitalized institutions? Which bank will be next? Is my money safe?

Numerous reviews, post-mortems and lawsuits will undoubtedly follow and the industry will ultimately emerge stronger. Right now, through the coordinated intervention of the Federal Reserve, FDIC and US Treasury, it appears as though the very real risk of system-wide contagion has been contained.

Prompted by recent events, when it comes to investing, this point-of-view advises readers to treat expert views with caution and extolls the merits of diversification. With that said, we argue that value – in the form of market capitalization – is migrating away from large-cap banks to payment stocks, powered the underlying fundamentals of two very different business models.

Treat expert views with caution

By all accounts, Silicon Valley Bank was a high-performer – tripling its deposits base in just a couple of years –and endorsed by numerous experts:

  • Forbes Magazine named Silicon Valley Bank to its list of “America’s Best Banks” just days before SVB’s ignominious collapse
  • Experienced investors with Venture Capital and Private Equity firms advised their portfolio companies to bank with Silicon Valley Bank,
  • Numerous equity analysts rated the stock as “Buy”

Yet, they all got it wrong. Perhaps the social media driven bank run was a ‘Black swan’ event that could not have been foreseen. Yet, the precursor event – rising interest rates – had started a full year earlier and had been well telegraphed (strangely, one arm of the Fed was increasing interest rates while another arm was designing stress tests that only contemplated an adverse macroeconomic scenario with lower interest rates).

The merits of diversification

If a well-regarded bank can fail, and fail so quickly, what should an investor do? The most basic answer is rule number one in investing: diversification.

To make the case for diversification (among bank stocks), we looked at the 10 bank stocks with the highest market capitalization1. These 10 banks form the backbone of the US financial system and generate 10% of all of the profits earned by the 500 largest American companies.

Among this group, four banks have assets of more than one trillion dollars: Bank of America, Citigroup, JP Morgan Chase and Wells Fargo. Five years ago, which bank stock was expected to outperform? With the benefit of hindsight, which stock actually delivered?

  • Only one of these four banks – JP Morgan Chase – grew its revenue over the past five years2
  • Despite flat revenue, Bank of America’s market capitalization experienced the greatest gain, increasing 41%

Overall, this group of large banks boosted both revenue and market capitalization by 15% over a five-year period. But, as illustrated by the four trillionaire banks, it would have been almost impossible to know a priori which bank would outperform its peers. A portfolio reduces the very real risk of backing the wrong horse.

A macro view of value migration

While it’s difficult/impossible to know which companies will do better than others within a specific industry, it should be possible to anticipate which sectors will gain share over time. Broader macro-level trends are observable and define the environment within which individual firms compete.

As an investor, it’s advantageous to bet on an industry where the tide is rising, since this will raise the water level for all ships. One such industry is payments, representing the convergence of financial services and technology.

As before, we selected the 10 largest payment companies with the highest market capitalization3. Almost every payment in the U.S. transacts with one of these processors and/or settles through one of these networks. Looking at the same five-year period, unlike banks, every one of these companies enjoyed revenue growth and:

  • Visa and Mastercard both more than doubled their profits
  • Block (aka Square) grew its revenue ten-fold in just five years, from $1.7 BN to $17.6 BN

The aggregate performance of this group, relative to their bank counterparts, is shown below. The market cap of the bank group increased by 15% while the value of the payment companies increased by 146% – or approximately 10x that of banks.

Market capitalization

* All of the numbers are in “$ Billions”

Payment companies facilitate commerce, reducing friction and enabling new business models (for example with embedded finance and micro payments), but without credit or liquidity risks. With strong fundamentals, the payments industry’s outperformance may well continue for years to come4.

Tony Hayes is the Founder and Managing Partner of Banking & Payments Group. He can be reached at tony.hayes@bankingandpaymentsgroup.com

1 The 10 most valuable US bank stocks are JP Morgan Chase, Bank of America, Wells Fargo, Morgan Stanley, Goldman Sachs, Citigroup, US Bancorp, PNC Financial Services, Truist Financial, and Capital One.

2 For the sake of this analysis, we used data from the Fortune 500 rankings. Revenue and profit data is annual, and market capitalization is as of the last day of March (in 2022 and 2017).

3 The 10 most valuable US payment stocks are Visa, Mastercard, American Express, PayPal, ADP, Block, Fiserv, FIS, Discover Financial Services, and Global Payments. ‘

4 As always, past performance is no guarantee of future results. The chart shows how the basket of payment stocks fared relative to its bank counterpart. The views expressed are solely those of the author and should not be construed as investment advice.